Causes of inflation

One of the main reasons the Reserve Bank of Australia (RBA) raises interest rates is to bring down high inflation. But what exactly is inflation, what factors push it upwards, and how does raising interest rates push it back down?

What is inflation?

Inflation is the rise in the cost of goods and services over time, reflecting the purchasing power of money in Australia. When people tell you how much cheaper it used to be to go to the movies decades ago than it is today, that’s partially due to inflation. 

The RBA tracks inflation using the Consumer Price Index (CPI), which is data collected by the Australian Bureau of Statistics (ABS). This report tracks price changes in Australia for a hypothetical “basket of goods” that includes:

• Housing
• Food and alcoholic beverages
• Recreation and culture
• Transport
• Furnishings, household equipment and services
• Alcohol and tobacco
• Health
• Insurance and financial services
• Education
• Clothing and footwear
• Communication

The ABS has been tracking CPI on a quarterly basis in the past, and in 2022 introduced a new monthly CPI report.

What causes inflation?

According to the RBA, there are three broad categories for inflation’s causes:

• Demand Pull: Caused when there is high demand for goods and services – for example, when it starts raining, umbrella prices at street vendors often rise quickly. Demand pull can also occur when consumers have more money available to spend. For example, during the COVID-19 lockdowns, many Australian households saved money that would have otherwise been spent on going out. When the lockdowns were lifted, these Australians were then free to spend this stockpiled cash, increasing the demand for goods and services.
• Cost Push: Caused when the supply of goods and services is limited or restricted. For example, if a tropical cyclone damaged Australia’s banana plantations, this could reduce the supply of bananas, pushing banana prices up in the shops. For another example, during the COVID-19 pandemic, lockdowns delayed a lot of international shipping, slowing down global supply chains. This made it harder to access new goods (such as new cars), which in turn pushed up the prices of existing goods already in the Australian market (such as used cars).
• Inflation Expectations: Sometimes called “inflation psychology”, this is where the belief that prices are going to rise leads Australians to make decisions that actually causes inflation to occur, as a kind of self-fulfilling prophecy. For example, when business owners believe inflation will rise, they may increase the prices they charge for their goods and services to help offset the rising cost of running their business. And if workers believe prices will rise, they may ask for higher wages to help preserve their purchasing power, which could lead to increased demand. 

Why does the RBA try to control inflation?

Some inflation in the economy could be considered a positive thing. If prices are rising, but Australians can still comfortably afford to pay them, this indicates that the Australian economy is growing. The RBA doesn’t want inflation to fall too low, as this indicates that Australia’s economy isn’t growing fast enough.

But if inflation gets too high, it becomes much harder for Australians to afford the goods and services they need, and changes how people make spending and investment decisions. At the time of writing, the RBA’s inflation target is between 2 and 3 per cent.

RBA governor, Dr Philip Lowe, has emotionally described high inflation as “evil” and “a scourge”, arguing that any pain caused by raising interest rates in 2022 would not be as bad as the long-term effects of failing to stop runaway high inflation. 

“The Board is committed to doing what is necessary to ensure that inflation returns to target over time. High inflation is a scourge. It damages our standard of living, creates additional uncertainty for households and businesses, erodes the value of people's savings and adds to inequality. And without price stability, it is not possible to achieve a sustained period of low unemployment. It is important, therefore, that this current surge in inflation is only temporary and that we once again return to the 2 to 3 per cent range.”

How does the RBA try to control inflation?

One of the main ways that the RBA attempts to manage Australia’s inflation is through the national cash rate. This is the interest rate that banks charge one another for overnight loans, which they use to access cash to provide their customers with financial services.

Because the cash rate affects the overall “cost” of money for banks and lenders, changes to the cash rate are typically reflected in changes to interest rates on loans and deposits. So, when the RBA lowers the cash rate, Australians may be able to pay less interest on loans but earn less interest from deposits. And when the RBA raises the cash rate, Australians can earn more interest on deposits but may pay more interest on loans.

Because raising the cash rate makes it more expensive to borrow money, Australians are more likely to slow their spending, reducing demand for goods and services. Pulling the brakes on the Australian economy like this can help lead to inflation falling over time. 

It’s important to note that raising the cash rate does little to affect the supply side of the inflation equation. According to RBA Governor Lowe, inflation is expected to moderate as global supply side problems ease over time.

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